Carbaugh, Chap. 2 1 Historical development of trade theory  Mercantilism  positive trade balance  Absolute advantage (Adam Smith)  Countries benefit from exporting what they make cheaper than anyone else  Comparative advantage (David Ricardo)  Nations can gain from specialization, even if they lack an absolute advantage Foundations of trade theory

Carbaugh, Chap. 2 2 Absolute & Comparative Advantage Comparative advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour NationWineCloth United States5 bottles20 yards United Kingdom15 bottles10 yards Comparative advantage: the US has an absolute advantage in both goods Output per labor hour NationWineCloth United States40 bottles40 yards United Kingdom20 bottles10 yards

Carbaugh, Chap. 2 3 Ricardo’s Comparative Advantage in money prices Comparative advantage Cloth(yards)Wine(bottles) NationLaborWageQuant. PriceQuant.Price US1 hr$20/hr40$0.5040$0.50 UK1 hr£5/hr10£0.5020£0.25 UK1 hr$810$0.8020$0.40 (at $1.6 = £1)

Carbaugh, Chap. 2 4 Marginal Rate of Transformation Comparative advantage A B C Slope = MRT = 0.5 Wheat

Carbaugh, Chap. 2 5 Production possibilities schedules: constant opportunity costs Comparative advantage Slope = 0.5 = MRT Slope = 2.0 = MRT Wheat

Carbaugh, Chap. 2 6 Trading under constant opportunity costs Comparative advantage A B C D E F Trading possibilities line (terms of trade 1:1) A’ B’ C’ D’ Trading possibilities line (terms of trade 1:1) Wheat tt

Carbaugh, Chap. 2 7 Production gains from specialization: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss)

Carbaugh, Chap. 2 8 Consumption gains from trade: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain TradeTrade(Loss)

Carbaugh, Chap. 2 9 Changing comparative advantage Comparative advantage MRT = 0.67 MRT = 0.5 Autos

Carbaugh, Chap Trade restrictions and gains from trade Comparative advantage A B C tt D E tt’ Crude oil

Carbaugh, Chap Production possibilities schedule under increasing costs Increasing opportunity costs A B Slope 1A = 1W Slope 1A = 4W Wheat

Carbaugh, Chap Trading under increasing costs: US Increasing opportunity costs A t US (1A = 0.33W) B C D tt (1A =1W) Trading possibilities line Wheat

Carbaugh, Chap Trading under increasing costs: Canada Increasing opportunity costs A’ t C (1A = 3W) B’ C’ D’ tt (1A =1W) Trading possibilities line Wheat